A discretionary rules-based trading system (I'm assuming you DO have a trading system, whether a complex algorithm, or 5 simple rules you follow) will have a built-in element for trading mistakes. The size of the permission for mistakes will vary for every trader. Perhaps you are a very disciplined trader and make few mistakes, or you may be a less experienced trader, make a lot of mistakes, and therefore you have a greater allowance in your trading system for your mistakes. Either way, a trading system should account for mistakes when calculating the expected annual returns of the system.
Discounting for Mistakes
A workable trading system assumes a positive return with a certain percentage return assigned to each trade. This is an average of the winning and losing trades in the system over a prescribed period of time, usually annually. We are not constructing a system here, just addressing the impact mistakes have on the system, so we will assume we have a system that returns on average 1% per trade.
Let's also absorb we take 20 trades per year, with our system returning 20% per year (we're not accounting for compounding our return here to keep it simple). In order to account for the cost of mistakes we make when using the system, we'll assign a cost per mistake. One-half of one percent is a reasonable number. We also need to assign an average number of mistakes. We'll say we average 10 mistakes per year, decreasing our return per year by 5% to 15% annually including our mistakes. This is a fairly common and simple way to account for the cost of mistakes.
When you trade successfully and make a good profit for your system, are you "happy" with the trade? Maybe you go out to dinner or buy your spouse a small gift to celebrate. I know I feel better about my trading when I 'm making money. It's a great feeling. You've entered the ring and come out a winner.
How do you feel when you are trading your system and you lose money? It's not a good feeling, but you know you'll have winners and losers in the system. And overall you'll make your 15% (using our imaginary system above). So while losing money never produces a good feeling, if you are staying in your system the feelings are manageable.
Now how do you feel when you make a mistake and lose money because you have broken one of the rules in your system? I know how I feel. Several words describe the feeling; Depressed, out of sorts, angry, sad, and my favorite, tilted. When I lose money because I have not followed my rules I go on tilt.
Trading on Tilt
Trading on tilt generally impacts your system in several ways. While we have assigned a cost to our actual mistakes (the 5% per year, or one-half of one percent per trading mistake), it is very difficult to assign a cost to trading on tilt. This type of trading can:
- Cause you to miss trades your system would have you take
- Cause additional mistakes as you try to "make-up" for the last mistake
- Force you to exit trades you are already in but which have not yet hit your stops or profit levels, simply because you are too busy to watch them; And
- Result in you abandoning your system for some period of time when your system may be working perfectly
Each trader is different and each trader will trade on tilt in a differently. In order to calculate the actual return of your system you should honestly determine how you trade when you trade on tilt. You should then account for that cost within your system. If you are serious about your trading, you should also work very hard to find a way to control your trading when you are trading on tilt.